In Germany, actions speak louder than words

June 27, 2012, 6:40 PM UTC

German Chancellor Angela Merkel

FORTUNE — While the markets fear the worst from this week’s upcoming eurozone summit, recent developments inside Germany could provide some much needed optimism in the long-running European debt crisis. In a surprising reversal from her former position, German Chancellor Angela Merkel, agreed this week to effectively bail out Germany’s 16 debt-ridden states and issue a common debt instrument, the Deutschland Bond. In exchange, the states agreed to give up certain fiscal powers to the federal government in Berlin, paving the way for Germany to form a stronger fiscal union with its eurozone counterparts.

German officials have tried to downplay the significance of the state deal as it relates to the eurozone debt crisis, but its timing and structure doesn’t seem like a coincidence. Merkel seems to be sending a message to her European counterparts that she is open to the idea of a similar debt-sharing arrangement across the eurozone. The state deal could be used as a template for creating a fiscal union and a common European debt instrument, known as a eurobond. Such an agreement would go a long way to stabilizing the crisis, allowing Europe to finally pick up the pieces and move on.

Unlike other European nations that have a unitary governmental structure, where nearly all power is centralized in the capital, Germany is a federation, where power is distributed between the capital and its 16 states, similar to how power is divided in the United States. The German states have very strong budgeting powers, giving them the ability to tax and spend as they please, without the need for approval from the federal government in Berlin.

Like many of the members of the eurozone, some German states have found it difficult to borrow money at low enough interest rates to continue funding their widening debt hole. To make matters worse, complying with the new EU fiscal pact, which is set to go into effect next year, will make it even more difficult for the states to fund themselves.

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Under the fiscal pact, which was agreed to by nearly all EU member states in January, countries are required to limit their total structural deficit to less than 0.5% of GDP. That means both Germany’s federal and state governments must comply. When all split up, the state and local governments in Germany will only be able to run a structural deficit of 0.15%. For many of the states, most notably those in the northwest part of the country, adhering to those rules would be impossible. For example, North Rhine-Westphalia, Germany’s most populous state, would be limited to taking on just 900 million euros in new debt in 2014, despite needing nearly 3.3 billion euros to stay afloat.

The states were understandably upset about having to comply with a dictum coming from Brussels. Even if they were on board with the debt limits, there was really nothing they could do to comply, short of implementing the kind of austerity measures that crashed the Greek economy. So over the weekend the federal government sat down with all 16 German states to try and hash out a way to comply with the fiscal pact. There was dissention among the states, as those with smaller budget deficits opposed any form of debt sharing. But they surprisingly came up with a solution, just in time for the critical eurozone conference this week.

Under the agreement, the states would surrender some of their fiscal autonomy to the federal government and the European Union, in exchange for some major debt relief. This plan would encompass a one-time transfer of cash of 580 million euros from the federal government to the states to alleviate budget shortfalls. It would also transfer day care and some elderly care funding from the state level to the federal level, taking a large funding burden off the states. And lastly, it would involve the issuing of a joint federal/state bond – the first of its kind, which the Germans so originally are calling “Deutschland bonds,” or simply, D-Bonds.

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The specifics of the plan are hazy as it is still unknown how D-Bonds would be issued and distributed. If they are issued by member states, then that debt will still pile up at the state level. While that would solve the issuing problem, as the federal government would backstop any losses, lowering state borrowing rates doesn’t solve the state budget deficit problem.

In either case, the agreement is still significant as it showed that the federal government in Berlin is indeed willing to underwrite others’ debts in exchange for greater fiscal power. It also shows that Germans are willing to play ball when it comes to forming a tighter fiscal union with Europe.

But German Finance Minister Schaueble told reporters after the agreement was announced  that the agreement did not mean that Germany would necessarily back a similar arrangement at the eurozone level, noting that, “…as long as the national states make the decisions, they have to be liable. If you can spend money on my tab, you won’t be thrifty.”

That of course goes to the heart of the dispute currently vexing eurozone leaders. They must all be willing to voluntarily give up some, if not all, of their fiscal decision-making power to a prudent central authority if they ever hope to pool their existing debt or issue new debt at the eurozone level.

The markets don’t have much faith that eurozone leaders will ever agree to such an arrangement, but the German story offers some hope. The transferring of power and debt within Germany shows that it is possible to hash out a compromise. It also shows that it is possible for former warring nations to come together and share each others’ burdens for a greater good. Germany has done it many times in its history, from its first unification in 1871 to its most recent unification in 1990. Both times, richer states took on the burdens of weaker states but later emerged as a much-stronger nation. Germany has shown again and again it is willing to step up to the plate. It is just waiting for the rest of the eurozone to play ball.